Prepayment Risk

What it is:

When a borrower prepays a loan, the borrower saves a lot of interest. But that means the lender also misses out on all that interest. Accordingly, prepayment can sometimes come with a penalty, and this is disclosed in the loan documents.

However, you may have noticed that most mortgageamortization schedules break mortgage payments out into principal and interest and that those first several payments are nearly all interest. Accordingly, this mitigates some of the lender's prepayment risk, because the longer John is in his house and the more payments he makes, the more of that $100,000 in interest he's giving the lender. In other words, he's paying most of the interest up-front. If John sells the house after, say, 20 years, when the lender has collected virtually all of its $100,000 in interest, the lender is subject to much less prepayment risk. That is, it doesn't forgo much interest if he sells the house and pays off the loan early.

People who invest in pass-through securities are also frequently concerned about prepayment risk. That's because those securities that receive payments from an intermediary that collects payments from a pool of assets. The most famous of these is mortgage-backed securities (MBS), which represent an interest in a pool of mortgage loans.

When people move, as we’ve seen, they sell their houses, payoff their mortgages with the proceeds, and buy new houses with new mortgages. When interest rates fall, many homeowners refinance their mortgages, meaning they obtain new, lower-rate mortgages and pay off their higher-rate mortgages with the proceeds. This means the lenders and the MBS investors miss out on interest income due to prepayment.

How it works (Example):

For example, let's say that John Doe borrows $300,000 to buy a house in Phoenix. The loan is a 30-year mortgage at 5% interest. The lender, Bank XYZ, expects to make, say, $100,000 in interest over the life of the loan.

John lives in the house for five years and makes his payments on time every month. However, in year six, he gets a job offer in Philadelphia and decides to move there. Accordingly, he sells his house. At the closing, the buyer gives John $500,000 for his house. John uses $250,000 to pay off the remaining balance on the loan instead of making 25 more years of payments. John has prepaid the loan, and Company XYZ has "lost out" on collecting, say, $70,000 of interest that it would have earned over the remaining 25 years of the loan.

Why it Matters:

Prepayment risk is the risk that a borrower will pay off a loan earlier than expected.

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